Why Try a Worker Co-op

Business owners should think carefully and develop a strategic plan for exiting a business. You, the business owner looking to sell, can leave your business by selling it to family members or third parties, merging it into a larger organization, selling it to employees through an employee stock ownership plan (ESOP), or by simply closing up shop. However, one often overlooked method that business owners, especially small to medium-sized business owners, might consider is having the employees form a worker cooperative. You can then sell the business to the cooperative with some possible tax advantages.

The benefits from this type of exit strategy are numerous. For the employees, a purchase of the business would mean job stability, more control over their careers, higher morale, and usually better productivity. unlike an ESOP, where the employees are simply beneficiaries of a trust holding their stock, with little management authority, in a worker cooperative the employees can directly operate the business. Through year-end distributions of net margins, the employee-owners build up equity accounts that act as their retirement nest egg.

Also, unlike an ESOP, there are no added administrative costs in forming or maintaining a worker cooperative and the regulatory environment

is much less strict. A cooperative is a business model, not an ERISA regulated retirement plan, and therefore it is governed by state incorporation statutes and federal tax statutes.

Selling to a worker cooperative is a business exit strategy that ensures your business will continue, while also providing the seller with compensation for creating and growing the business. If the sale to employees is completed over a number of years, you could continue with management and training until the sale is finished. Note that not all the employees of a company have to become member/owners of the worker coop. But for those who choose to become owners, they can be trained in the responsibilities of ownership and management, giving you assurance that the company will continue as planned. The sale of the company to the employees can take place on a designated date or over a substantial period of time (such as five to ten years). This would allow the employees or the co-op to pay the entire purchase price over several years, often out of net profits. Rhere is the possible favorable tax treatment for you, the selling owner under internal revenue code §1042 (26 u.s.c. § 1042).

Section 1042 Tax Treatment

Code §1042 allows you to sell your stock to a worker cooperative with resulting favorable tax treatment. To qualify for the favorable treatment under §1042, the proceeds from the sale of your interest in the company must be reinvested in a “qualified security,” and the gain then is deferred indefinitely. In other words, the capital gains that result from the difference between what you invested in the company and what you receive upon sale will not be taxed unless or until you sell the “qualified security” that you purchased from the proceeds of the sale. And then the gain will be recognized as a long-term capital gain only to the extent that the amount realized on the sale exceeds the cost to the owner of the qualified replacement property (26 U.S.C. 1042(a)(3)).

For a very simple example, say you invested $100,000 in your company and over the years it has gained in value. You sell the company to a worker cooperative for $1,000,000. You use those funds to purchase a qualified security (like Apple or Amazon stock). When those shares are sold in the future, the tax will only be on the difference in value relative to when you purchased the Apple stock and when you sold it. If you don’t sell it and the Apple stock becomes part of your inheritance, there will be no capital gains tax liability to you or your heirs. If you have not used the §1042 advantages, then you will be required to pay capital gains tax on the $900,000

Specific requirements must be met before §1042 is available to you. To qualify for § 1042 treatment, there is a four-step process:

The sale of the company’s stock must be to an eligible worker-owned cooperative or to an ESOP.

The worker cooperative must own at least 30% of the total value of all outstanding stock, or of each class of outstanding stock, immediately after the sale.

The taxpayer (either you or the cooperative) must file a written statement with the IRS consenting to the application of §§ 4978 and 4979A with respect to the owner or the cooperative.

Your holding period with respect to the purchased qualified securities must be at least three 3 years (determined as of the time of the sale).

The first step is satisfied by the formation of a cooperative under Title 7, either Article 56 or Article 58, of the Colorado statutes.

The second step requires some financial planning on your part and the employees who will be purchasing the business. You have to look seriously at your employees and have lengthy discussions with them about potential ownership. Not all employees may be capable or willing to become owners. You may have to bring in a new person who will eventually replace you as the senior manager if you do not have personnel you believe can be trained to do what you do. Then you must determine the value of the company, which may require the services of a business valuation professional. The employees will be required to find a way to purchase at least 30% of the business the first year of the sale. This may require the employees to obtain a loan or other funding sources for the initial payment. There are other financing options available, such as an owner carry-back, or the cooperative itself executes a loan for the 30% initial payment. The remaining 70% of the purchase price can be paid over a number of years, as determined up front by you and the new employee-owners.

The money you receive for the sale of the business must be invested in qualified replacement property for a minimum of three years. “Qualified replacement property” is defined in the Code, but the definition is a little cumbersome. Generally, it means any security issued by an active domestic corporation that is not issued by the company being sold and that does not have passive investment income in excess of 25% of the gross receipts of the corporation for the preceding tax year.

Codes §§ 4978 and 4979(a) concern tax on certain dispositions by cooperatives and generally provide that there will be a tax imposed if the cooperative sells the securities it purchased from the owner before the three-year holding period provided in step 4 above is concluded. Of course, a tax professional should be consulted concerning whether a §1042 election is appropriate or even warranted for your particular business.

Example

As a simplified example of how this might work, suppose that a company has ten employees and you wish to sell the company for an agreed-on value of $750,000. All of the employees wish to purchase the company from you (although it is possible to sell the company to fewer than all employees). The employees form a worker cooperative and purchase the entire company.

The employees purchase at least 30% ($225,000) in cash on the date of sale and the new cooperative signs promissory notes to you for the remaining 70%. You use the $225,000 to purchase qualified replacement property to be held for at least three years. You and the employees are now owners of the cooperative, each with one vote and each with the power to participate in the governance of the company. As part of the agreement between you and the new employee–owners, it could be provided that you retain certain management authority or a Board seat until more of the notes are paid.

Over a period of years (all as agreed), either the cooperative itself or the employees can pay for the remaining ownership interests. Payment can be made from net margins or by the employees making additional capital contributions, or by raising capital from non-member outside investors (e.g. through a private placement offering, a crowdfund offering, or a direct public offering).

Eventually, you are paid in full and can retire, knowing that your company will continue with owners that you have trained and who you believe will continue your legacy. The community has not lost a business and its tax base, the employees have job stability, and their families have the knowledge that a nest egg is growing in the company. When an employee leaves the company or retires, the cooperative can redeem his or her equity account over a period of time or all at once, as agreed by the employee–owners.

Conclusion

The worker cooperative is a flexible business model that can be used by any group that is interested in creating a democratic decision-making company that benefits the employee–owners with job security, a sense of pride, and possible retirement income. In today’s economy, many small business owners would like to retire or at least start planning their retirement. However, they may find that there are very few opportunities to sell their businesses to a third party, and family members may not want to continue the company. By using a worker cooperative model and selling your business to employees who have the knowledge and enthusiasm to continue to provide products or services, you can feel good about passing the business along to someone who cares.

My journey to the practice of law has not been linear. My sensitivity to injustice and inequality, on the other hand, has been a constant driver. I’ve always been in search of a solution, which led me to seek a deeper understanding of the systematic ways inequality has been ingrained into the fabric of society, which led me to law school. If you had told me when I was eighteen that eventually I would come to the realization that a piece of the solution was dependent on reforming corporate governance, I would have scoffed indignantly at the idea that corporations could be anything but evil money-making machines.

I’m not sure when the switch flipped, but sometime during law school I began to see how corporations could be leveraged as a solution if we recast the role they play in society. As my colleague, Lenore Palladino, writes in her recent blog post on corporate governance, “Why Workers on Corporate Boards Just Makes Sense,” corporations are run “according to a neoliberal model of shareholder primacy,” but that doesn’t mean they have to continue to be run that way or that it even makes sense. Corporations can and should be run differently. The corporate form and its many variations can be used to create economically viable businesses that benefit workers and communities, that are good stewards of the environment, and that demand capital in service of stakeholders.

Giving workers a voice in their companies, if not an ownership stake, has a role to play in breaking the extractive cycle corporate American has been in for much of modern history. Positioning workers so that they have a say makes sense from a practical point of view too. Without workers corporations don’t create value for anyone. Workers are the face of a business, they deal with customers and understand the day-in and day-out operations in a way the C Suite cannot. Placing workers on corporate boards also creates more accountability for companies that claim to consider all stakeholders in decision making. As Lenore points out in her article, giving employees board representation puts stakeholders on the board, creating a board that inherently governs for its stakeholders and not just shareholders. Often self-interest is viewed negatively, but when you consider creating a board where a variety of self-interests are represented, it can be leveraged to accomplish measured and equitable outcomes that benefit society as a whole.

Cooperatives are the original social enterprise business model and Colorado is emerging as the “Delaware of cooperative law,” thanks in no small part to limited cooperative associations (LCAs), authorized by C.R.S. Title 7, Article 58. The limited cooperative association is a relatively new entity type, adopted in Colorado in 2010. It offers a balance of flexibility, self-determination, cooperative identity and fundamental protection for the cooperative principles and economic structure. As of 2017, LCAs can also elect the protections and privileges of the Colorado Public Benefit Corporation Act.

Longer-term horizon and non-liquidity based options available for equity redemption and planning purposes

Investments and ROI

Like traditional corporations, public benefit corporations, or LLC’s, LCA’s can generate returns for investors. LCA’s operate with pluralistic purpose, for the benefit of members, to generate a profit, and to tend to the interests of other stakeholders, including investors. LCA’s distribute profit to their members on the basis of “patronage”; the value of goods or services contributed to or purchased from the LCA, and to investors based on the relative amount invested. Subject to certain limitations, LCA’s can generate returns for investors based on profitability, distributions on profitable asset sales, refinancing, or through a liquidity event. LCA’s, as member-owned and democratically-governed entities, seek to grow and operate sustainably for the benefit of their members, and thus do not set out with the objective of demutualizing or undergoing a liquidity event. Consequently, the primary mechanism for generating a return on investment is through sustainable operations and profitability.

More recently, multi-stakeholder start-up LCA’s have been using revenue-based financing mechanisms to raise capital, offering investors a return of up to a multiple of 1-5x the original investment, or a fixed percentage of profit for a fixed duration of time. Once the cap is reached, the shares are treated as automatically repurchased. These instruments are sometimes called demand dividends. Even Silicon Valley and New York VC’s are catching on to revenue-based financing and alternative business models as a way of helping to build a more sustainable and healthy business.

Non-exhaustive list of examples of seed-stage investment terms based on recent offerings.

Equity equivalent investment type:

“Capped Return, Self-Redeeming”

“Profit Share, Self-Redeeming”

“Hybrid Profit Share – Capped Return”

“Target Dividend”

Original investment (e.g.)

$500,000

$500,000

$500,000

$500,000

Return

3x cap, no pre-set profit allocation

X% of profit for 5-years.

Greater of Cap or X% of profits for 5-years, with true-up within 90-days of 5-year anniversary

Target 5-8% annual dividend (non-cumulative)

Liquidity

Priority distribution of Cap, less prior distributions before any distributions to members

Management and operation of a law firm has taken many forms over the years and we are exploring new, innovative ways to run our firm. We are experimenting with the use of democratic principles, Teal, and self-management to develop a style that works for us and our clients. Earlier this week, Jason sent an article around to the team that highlighted The Wellington Community Law Centre (WCLC), a New Zealand law firm that went from a traditional hierarchical management system to fully self-managed in six months. Our firm has been discussing and implementing self-management techniques and it was inspiring and encouraging to read about WCLC’s journey. While reading the article I was tripped up by the reference to “advice process.” I had never heard the term before and we haven’t formally chosen a decision-making process to adhere to, so I did a little research. In a nutshell, advice process is an alternative to top-down and consensus decision making. Instead of executives or leaders making decisions, the employee who notices the problem or opportunity is empowered to act on that knowledge and becomes the decision-maker. The decision maker must seek input and advice from the relevant team members, leaders, and stake holders, but is ultimately responsible for creating a proposal and deciding what action to take. The process resonates with me because even as the least experienced member of our firm, I feel empowered to make decisions and suggestion for improving processes or creating new ones. I’m comfortable approaching the more senior attorneys to discuss my ideas and get their feedback and I’m able to pursue projects that interest me and be an active participant in my career development.

My favorite quote from Geoffrey Roberts, the general manager of WCLC, was, “When you treat people with high levels of trust, then they will live up to that. They will give you much more than you can imagine. Anecdotally, I argue that high levels of trust result in high levels of engagement and flexibility.” Perhaps more than anything else discussed, I feel that building trust is critical. For me, feeling trusted makes me feel like I can make mistakes and that I will get productive feedback that will help me grow as a lawyer. Having trust also means that I’m not afraid to come forward when I have made a mistake or to be held accountable for a decision I made. One way our firm fosters a trusting environment is through quarterly retrospectives. Retrospectives give us the chance to reflect on what is and isn’t working – they also help remove the negative connotations from accountability. Instead of accountability being scary, it simply becomes an opportunity to celebrate a win or learn from a decision that didn’t work out.

As a member of a law firm that is treading an unconventional path, I love seeing what WCLC has been able to accomplish. It gives me hope for the future of the profession and it’s nice to know our firm is in good company.

Last week our team held its first legal café at Green Spaces in Denver. We welcomed a group of approximately thirty entrepreneurs and discussed the nuances of entity choice. Our team was excited for the launch of what we hope will become a mainstay for the firm and a valuable resource for our community. We selected entity choice as our first topic because this early decision can often have far-reaching consequences for businesses. The right entity is critical for many aspects of the business, from protecting the social mission to attracting outside capital. Our hope is that we can help early stage entrepreneurs avoid the pitfalls of choosing an entity not well suited to their long term vision. To that end we created this presentation with an overview of entity types and strategies for choosing the right entity. Those who attended the legal cafe also had the opportunity to participate in an hour of small group Q&A with our team.

The event exceeded our expectations and our team is looking forward to hosting future legal cafes that provide useful information to entrepreneurs at all stages of developing their business.

A strong and supportive community can enable and catapult any entrepreneur to success. This is even more true for social entrepreneurs, those who find solutions to the most pressing social and environmental problems of our time. As an aspiring social entrepreneur, I can attest to the fact that my community became my champions, confidants, partners, teachers, and emotional support, without whom starting a business would have been a whole lot harder.

Jason Wiener | p.c., a mission-driven company, believes in supporting our community by designing legal and business solutions that empower social entrepreneurs to find solutions for the most pressing social and environmental issues of our time. However, to get these innovative businesses off the ground, social entrepreneurs need to navigate a maze of options and regulations – a daunting and sometimes expensive task.

Colorado is one of the most beautiful and exciting states to live in, which is simultaneously experiencing unprecedented, often inequitable and unsustainable growth. We need social entrepreneurs that come up with equitable and empowering solutions for our communities. As a social enterprise, we understand this need and supports social entrepreneurs. We have the expertise, willingness, passion, knowledge, and ability to support social entrepreneurs to form their business, navigate the regulatory environment, and provide business solutions tailored to each venture’s needs. To expand access to this information and high quality legal services, we have launched a pro bono initiative tentatively called the “Community Wealth Building Legal Café” in Denver, which will provide basic legal guidance on the elements of starting up an impactful social enterprise.

During our first legal café, we will discuss one of the first challenges that entrepreneurs face when starting a business: choosing a business entity that truly fits the entrepreneur, as well as the business’s, needs. Figuring this out can be time-consuming, confusing, and often costly. At this legal café, we will give a thirty-minute presentation on the diverse types of legal entities that entrepreneurs can consider, the pros and cons of each, and how to set these up. We will specifically focus on inclusive and engaging business models that have shared ownership at its core. Employee ownership more equitably distributes power and capital by allowing employees to have a purposeful stake in the businesses.

This legal café will be held at Green Spaces, a co-working space in Denver. After the thirty-minute presentation we will open the floor to questions. A team of attorneys from Jason Wiener | p.c. will be there to answer all questions about legal entities, social enterprise, and shared ownership. A free light lunch will also be served. Registration is also free. Register on Eventbrite on or before Tuesday, March 27.

If you’re one of the many who have been moved to take matters into your own hands and ensure that your retirement accounts are divested from sin-sectors, such as fire-arms, alcohol, tobacco, petroleum, mining, or other companies and industries that extract from the earth, people or communities, you may be asking “now what?” The divestment movement reached a fever pitch when organizations like 350.org and communities around the country compelled foundations, universities, pension funds, and municipal treasuries to take a critical eye to endowment investments to ensure they weren’t invested in companies and funds that were causing or exacerbating climate change.

If the latest bout of news has you thinking about doing your part, we’ll happily take a break from our usual work to help share tips for how to proactively invest in greater alignment with your values.

Take note: we are not financial planners or advisers. You should consult a licensed financial planner and tax adviser when considering acting on any of this information. This blog comes from my personal journey to invest retirement savings in my local community and in companies and funds that I believe are part of the solution. We are not experts at this and others have written more prolifically about the subject.

Move your money out of an investor-owned bank and into a community credit union. After the Occupy efforts dwindled, one of the things that my family felt it could do was move our banking to our local credit union. Credit Unions are cooperatively owned banks – they exist to serve their members, not Wall Street shareholders. There is a huge multiplier effect when you bank with a local credit union. Fees and interest get reinvested into the community. We bank with Elevations Credit Union, the largest credit union in Boulder County. It turns out Elevations C.U. is also the largest originator of mortgages in Boulder County, making it one of the most important pathways to home ownership.

Give preference to mutual insurance companies. Again, mutual insurance companies are cooperatively owned insurance companies. Mass Mutual, Northwestern Mutual, Liberty Mutual…get the picture? Many insurance products are simple commodities and can be purchased through any broker. It may not seem like a radical act, but choosing a mutual insurance company over an investor-owned insurance company is a big deal. It sends an important signal and it helps demonstrate the power and reach of economic democracy. I just clicked “submit” on our director election e-ballot; how often do you feel you have a say in the governance of the company that holds your life insurance policy?

STOP TAKING UBERs and LYFTS. Better yet, #deleteuber and #deletelyft. In many big cities you can easily find a taxi company or a ride hailing service that is cooperatively owned. For example, in Denver/Boulder, we helped Green Taxi Cooperative form and obtain regulatory approval. The upshot is that you’ll be riding with a licensed, insured, professional taxi driver, not a college kid who has been up for 36 hours straight and is trying to earn some extra money between classes. If you really want to put your money where your heart is, then ask yourself whether you should hail a ride from companies that average $3.37/hour wages for drivers. I say #gocoop and #gocooptaxi.

If you’re like 98% of us, you’re not an “accredited investor.” This means that until recently you were all but forbidden from investing in privately held companies. This all changed with the JOBS Act. Title III, in particular, paved the way for non-accredited investor crowd-funding. Subject to certain investment limits, ordinary people can invest directly into privately held companies. This means it is now easier than at any time in the last 80-years to actually invest in your favorite local business. You’ll have to invest through an online portal, and there are many out there. Check back soon; we’ll be publishing future blog posts about crowd-funding, direct public offerings and other ways to invest in local businesses.

Last, but not least…shop local and shop coop. Local buying and community purchasing is by far the most effective and direct way to support local business, keep money local and vote with your feet (or is it dollars?). Why shop at Home Depot when you can shop at a local Ace or True Value Hardware store? Did you know that both of the latter are cooperatives? Each store is independently owned and the store is a member of a wholesale purchasing cooperative. This allows each store to achieve economies of scale with other coop member stores. This aggregated purchasing power translates into better prices for customers. Locate your closest food coop! If one doesn’t exist, help to start one.

The bottom line is that once you divest, you’ve got to INvest. It can be overwhelming with so much to learn and so many options to explore. Remember, you’re not alone. It doesn’t just take a village…it takes a community. Good luck and please share your tips and experiences!

We are announcing a new video blog FAQ series. We will release short videos to answer the questions we are frequently asked. If you have questions, you can contact us using the link at the bottom of the website and you should register for our distribution list. I hope you enjoy and leave comments with your feedback.

What Is Distributed Ownership?

Why Sell My Company To Employees?

I Want Shared Ownership, What’s Next? (I also wrote a blog post about this topic)

I received a familiar email from a long-time friend and start-up founder. She has founded a unique brand and business model that has created a market where one had not previously existed; the dream of most entrepreneurs. The start-up has grown rapidly and has received international acclaim in mainstream press. A great position for any growing start-up to be in, right? Like many start-ups, however, cash is scarce and “sweat equity” is abundant. She said: “I’m not ready to invest in turning my business into a full-fledged cooperative, but I’d like to start down the path. What can I start doing now?”

I hear this question a lot. I hear variations of it is as well. They go something like “I want to run my business as a cooperative, but:”

“I have heard that cooperatives are run as not-for profits.” Or

“I am afraid of sharing ownership and diluting what I’ve built.” Or

“I don’t know if I’m ready.” Or

“I don’t fully understand what it means to operate as a cooperative or with shared ownership.” Or

“I don’t know if my team of employees wants to co-own this business.” Or…

You get the picture. Decisions about ownership are the most intimate and consequential decisions a founder makes. Hesitation is natural, if not expected. Here is more or less what I told my friend:

Under the cooperative laws in many states, you cannot technically call a business a “cooperative” unless you form under that state’s cooperative laws, or you operate on a cooperative basis. Additionally, there are significant tax, securities, contractual and other legal considerations involved in operating on a cooperative basis and sharing ownership, and so you should consult an attorney.

You can, however, start by adopting cooperative practices and principles:

You could start practicing open book management and collaboration. You could schedule regular conference calls to discuss the business’ finances with team members and employees.

Ask team members and employees to vote on things. Start small; have folks vote on the type of coffee to buy. Progress at a natural pace to more consequential decisions.

You could start offering financial incentives to employees and team members, tying revenues and/or profit to compensation.

You could operate as a benevolent dictator and open up decision-making to a consensus or democratic process. You would of course retain the final and definitive vote as the business owner.

You could create committees to focus team members and employees on various aspects of the business, giving official responsibility and even equity compensation for participation.

You could create and offer phantom equity or equity appreciation rights by way of contract so as not to complicate your capital structure. I disfavor phantom stock and stock appreciation rights as a definitive ownership sharing technique, but they can be an effective and efficient bridge to meaningful shared ownership.

Consider whether to you want to grant ownership rights or sell them in exchange for capital contributions.

Consider whether to allocate ownership based on a retrospective or prospective measurements of “sweat equity.” Equity ownership can be allocated both statically and dynamically. For example, check out the encode.org “for purpose entity” structure, and “Slicing the Pie“.

You may be familiar with stock options plans. While widely used, I tend to disfavor them as a device to confer meaningful and direct shared ownership. Stock option really only make sense when a business is cash strapped, but growing quickly and anticipates significant future profitability or a liquidity event (company sale, IPO). Stock options offer a tax-advantaged mechanism to pay service provides/contractors/advisers/employees with equity rights that are not taxed until the option is exercised. Stock options plans are somewhat expensive to set up and administer and annual valuations are required. Stock options rarely come with voting rights and the the options holder often cannot exercise ownership over the underlying equity until the options have vested, and the options are exercised.

***

Divying up ownership is one of the most consequential decisions an owner will make. Start with democratic management practices first, and then consider economic democratization with hybrid structures like phantom equity or equity appreciation. Once you have a clearer picture of the scale potential of the business and your desired ownership design, it makes more sense to formalize a shared ownership structure.

A cooperative structure need not be the only way to share ownership. There are numerous structures to consider and each offers a unique blend of pros and cons.

Lastly, talk about your journey and tell your story! It is important for other business owners to hear that they are not alone. Check out the 4-part series of our client dojo4’s journey to become a worker-cooperative.